At the New York Fed: Twelfth Annual Joint Conference with NYU-Stern on Financial Intermediation

Summary:
Michael Blank, Nicola Cetorelli, and Anna Kovner
Anyone who has a savings account, has taken out a mortgage, or has been part of a business seeking new capital has relied on the smooth functioning of the institutions and markets that collectively perform financial intermediation. Because financial intermediation is so critical to the functioning of a modern economy, it is important to understand its inner workings—its fundamental features, recent innovations, lines of transmission to real economic activity, its imperfections, and its interactions with regulatory policies. As part of an ongoing effort to foster such an understanding, the New York Fed recently hosted the twelfth annual Federal Reserve Bank of New York–New York University Stern School of Business Conference on

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Anyone who has a savings account, has taken out a mortgage, or has been part of a business seeking new capital has relied on the smooth functioning of the institutions and markets that collectively perform financial intermediation. Because financial intermediation is so critical to the functioning of a modern economy, it is important to understand its inner workings—its fundamental features, recent innovations, lines of transmission to real economic activity, its imperfections, and its interactions with regulatory policies. As part of an ongoing effort to foster such an understanding, the New York Fed recently hosted the twelfth annual Federal Reserve Bank of New York–New York University Stern School of Business Conference on Financial Intermediation. In this post, we explore some of the discussions and findings from the May 5 conference, which focused on recent advances in the study of financial intermediation.

The Role of Collateral
Collateral facilitates lending in financial markets. Awareness of the functions and features of collateral is thus necessary for understanding how financial markets operate and identifying appropriate policy designs. In the conference’s first presentation, Dong Choi described his theoretical work with coauthors João Santos and Tanju Yorulmazer on the central bank’s optimal lender-of-last-resort (LoLR) policy given the role of collateral in interbank transactions. Though it is crucial for policymakers to understand whether and how to supply financial intermediaries with liquidity in times of market stress, a rigorous theoretical foundation does not yet exist to evaluate LoLR policy and its interactions with the modern financial system. Choi and his coauthors find that under certain conditions, the central bank can actually impair interbank lending when it lends cash against high-quality (as opposed to low-quality) collateral, since this intervention deprives the system of the collateral that is the bedrock of a smoothly functioning interbank market.

But why is collateral so widely used in lending arrangements in the first place? Adam Copeland addressed this question in his presentation. Copeland and his coauthors, Viktoria Baklanova, Cecilia Caglio, and Marco Cipriani, try to distinguish between two possible roles for collateral: as an enforcement mechanism, whereby an entity demands collateral so that counterparties are incentivized to return borrowed cash or securities, or as a screening mechanism, whereby an entity utilizes collateral to tease out low-risk from high-risk counterparties. By analyzing data on the bilateral securities financing market, the authors find evidence that enforcement is not the only purpose of collateral and that collateral is also used for screening at least in some parts of the market.

How Financial Intermediaries Support the Creation and Spread of Information
An underappreciated role of financial intermediaries and markets is to facilitate the production and dissemination of information about financial assets, from small loans to stocks. How do markets and intermediaries fulfill this purpose? Marco Di Maggio presented evidence on the role played by brokers in information diffusion. Di Maggio and his coauthors, Francesco Franzoni, Amir Kermani, and Carlo Sommavilla, show that when one of a broker’s institutional clients (such as a hedge fund) instructs the broker to execute a large trade, the broker’s other important clients tend to make the same trade shortly thereafter. This finding is consistent with the hypothesis that when an institutional investor possesses information about an asset’s value that is not yet known to other market participants, the information is shared with the broker’s other clients. In this way, brokers may support the spread of new information and expedite the adjustment of asset prices to the new information.

The creation and dissemination of information is an area of financial intermediation that is subject to significant change as technologies and institutional forms continue to evolve. This subject was examined in Nicolas Serrano-Velarde’s presentation of work coauthored with Julian Franks and Oren Sussman about an online U.K. marketplace in which retail investors can directly offer small loans to potential borrowers. The authors find that retail investors act analogously to traditional financial intermediaries like banks in that they produce “soft,” less readily available information in deciding which interest rate to bid for a given loan. However, the authors also discover that this information is not as precisely reflected in interest rates when there is supply-demand imbalance for loans. In this way, even innovative modes of financial intermediation like online marketplaces must grapple with some of the fundamental problems faced by traditional intermediaries—in this case, how to aggregate information into lending decisions in the face of volatile liquidity flows.

The Effects of Financial Intermediation on the Real Economy
The ultimate purpose of financial intermediaries is to facilitate transfers from savers to borrowers to finance growth. It is thus important to understand how the institutional features and potential instabilities of intermediaries affect the availability of credit to the real economy. Liquidity-constrained individuals sometimes turn to short-term, high-cost loans to obtain much-needed cash. As Andres Liberman explained, he and his coauthors, Daniel Paravisini and Vikram Pathania, use data from a high-cost U.K. lender to examine how high-cost debt can affect borrowers aside from just the direct burden of the high interest rates. Such debt may diminish the borrowers’ creditworthiness in the eyes of future lenders, owing to the relatively risky nature of the typical high-cost borrower. Indeed, the authors find that high-cost loans only harm the future access to credit of borrowers with relatively high credit scores, suggesting that negative effects of high-cost debt may be restricted to borrowers who have good reputations that can be weakened by the loan.

During the conference’s final presentation, the topic turned to business credit when Andrea Presbitero discussed how credit may be shut off to a broader swath of firms during periods of financial instability. Presbitero and his coauthors, Fabio Berton, Sauro Mocetti, and Matteo Richiardi, evaluate how small Italian firms coped with reductions in bank credit supply during the financial and eurozone crises from 2008 to 2012. They find that firms significantly cut employment as a result of the supply shocks, with less-skilled workers on temporary contracts suffering the brunt of this contraction. As such, the authors show that instability of financial intermediaries can have distributive effects, underlining the crucial role that financial intermediation plays in the real economy as well as the far-reaching consequences that a breakdown in intermediation can have.

Post-Crisis Banking Reforms: A Panel Discussion
The conference also convened a panel on post-crisis banking sector reforms featuring a wide range of voices, including Greg Baer, president of The Clearing House Association; Nellie Liang, senior fellow at the Brookings Institution and formerly the director of the Office of Financial Stability Policy and Research at the Federal Reserve Board; Andrew Metrick, professor of finance at Yale and program director of the Yale Program on Financial Stability; and Marcus Stanley, Policy Director of Americans for Financial Reform. Panelists discussed which post-crisis regulations are most beneficial to the performance and stability of financial intermediaries, which are most counterproductive, and what changes or additions should be made to the current post-crisis regulatory framework. The panelists’ views reflected their diverse perspectives and experiences. For instance, while some expressed concern about the Supplementary Leverage Ratio’s (SLR) potentially distortive interactions with other regulatory changes (like the Basel liquidity regulations), others supported the SLR as an important backstop to risk-weighted capital requirements. Overall, the panel highlighted the many areas of regulatory policy that continue to be debated in the effort to construct a healthy and safe system of financial intermediation that efficiently supports real economic activity.

Disclaimer The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Michael Blank is a senior research analyst in the Federal Reserve Bank of New York’s Research and Statistics Group

Nicola Cetorelli is an assistant vice president in the Bank’s Research and Statistics Group.

Anna Kovner is a vice president in the Bank’s Research and Statistics Group.

How to cite this blog post:
Michael Blank, Nicola Cetorelli, and Anna Kovner, “At the New York Fed: Twelfth Annual Joint Conference with NYU-Stern on Financial Intermediation,” Federal Reserve Bank of New York Liberty Street Economics (blog), June 23, 2017, http://libertystreeteconomics.newyorkfed.org/2017/06/at-the-new-york-fed-twelfth-annual-joint-conference-with-nyu-stern-on-financial-intermediation.html.

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